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Thursday, November 26, 2015

Forecasting Japan: 25 Years Later

Summary

Editor's Note: Since the end of the Cold War, the Pacific Rim has seen China rise and Japan stagnate. However, Japan is approaching an epochal shift that will enable it to challenge the current order. This analysis is the fourth and final part of a series that forecasts the nature of that shift and the future of Japan. Part one explored the origins of Japan's slow-burning crisis. Part two examined the rise of China and its impact on Japan. Part three assessed the failure of Tokyo to enact meaningful reforms.

In the coming years, Japan will transition out of its slow-burning state of crisis as it seeks to make a radical break with its current, decaying Cold War political order. The transformation will take place against the backdrop of significant demographic changes. Since 2005, Japan has seen its 65-and-over population grow by more than 33 percent, faster than any past or future forecast rate. Over the next decade, this rate of aging will slow substantially, as will the decline in Japan's working-age population. These trends will persist until around 2040, when most of those born in the country's 1968-1976 baby boom will have entered retirement. Then, between 2035 and 2045, the rate of the working-age population's decline will pick up slightly, increasing pressure on the system. By 2060, the situation will become dire. Even under constant fertility conditions, Japan's population will fall to around 86 million; if fertility declines, population levels will drop further still to 79 million. As a result, Tokyo will likely be increasingly confronted with internal issues related to economic and social management in the years after 2040.

Analysis

In the next five years, Japan's break from the post-Cold War period will begin. Tokyo will start to dismantle key elements of its current political order and the reforms that have made that order more democratically accountable. The process will require substantial changes in the relationships between the Liberal Democratic Party, civil service and keiretsu, and Tokyo will have to find some way to curb or eliminate the electoral strength of economically non-competitive public utilities while offsetting the growing power of the over-65 voting population. Meanwhile, the Japanese government will need to make reforms to improve the productivity, efficiency and competitiveness of Japanese businesses. Only these changes will ensure that Japan can cope with the acute population aging and workforce shrinkage it will face in the decades after 2020 while guaranteeing the country's national security.

Over the next two years, Tokyo will focus on achieving Japanese Prime Minister Shinzo Abe's "virtuous circle." Each of Abe's proposed economic reforms aim to address the root causes of underemployment, with the hope that higher employment will drive up domestic consumption, thereby boosting the economy and raising employment levels even further. This cycle will need to be in place before the Bank of Japan pulls back on monetary easing or the central government is forced to improve its fiscal position by raising the national sales tax or increasing corporate taxes. The bank's current rate of bond purchasing is unsustainable, and Stratfor expects that the Bank of Japan will cut back on its bond purchases, perhaps significantly, before 2017.

While the prime minister's "Abenomics" measures will make some progress before 2017, the administration's efforts are not extreme enough to put Japan back on the path toward sustainable growth within the next two years. The weak economies of both China and Europe – key destinations for Japanese exports – will make this outcome even more unlikely. Therefore, when the Bank of Japan inevitably pulls back on its bond purchases, Japanese companies with extensive overseas operations will see repatriated funds decline in value, which will reduce their incentive to invest domestically. The cost of Japanese goods will also rise yet again, eroding the country's competitiveness with China and South Korea.

The drawdown in bond purchases and declining investment will lead to fiscal deficits for the Japanese government, putting pressure on Tokyo to raise taxes on either companies or individuals. Whichever Tokyo chooses, by the start of 2017, it will once again find itself facing a dilemma after a short period of economic growth.

But Abenomics will not implode. The Japanese government will likely find a way to avoid defaulting on its sovereign debt and the Bank of Japan will manage to implement a modest amount of monetary stimulus without undermining the country's sovereign debt markets. Inflation may hit 2 percent, wages may rise and Japan will likely succeed in attracting some foreign investment into long-protected sectors and new industries. Abenomics is fundamentally sound and economically rational, but its economic benefits in the long term will be preceded by hardship for individuals. In 2016, as Japan's growth picks up, these side effects will become slightly less glaring, but if the Bank of Japan pulls back on bonds and the government raises taxes, they will resurface.

Life will not substantially deteriorate for ordinary Japanese people, but events will hurt the prime minister and his administration at the polls. Abe survived the December 2014 elections because of an incoherent opposition, but Japan's fragmented playing field will not last forever. By 2017, dissatisfaction among older voters, especially those with ties to the agriculture lobby or to other keiretsu, as well as middle-aged and older small business owners, will begin to undermine Abe's electoral position.

A Quiet Revolution

The fate of the Abe administration will have relatively little bearing on whether the core policies of Abenomics persist. Over the next five years, two trends will emerge, the first being the rise of a new generation of bureaucrats dedicated to the reforms necessary to ensure Japan's long-term security. At the same time, an older population averse to those reforms, especially military normalization, will come to dominate the electoral system. Since avoiding reform is not an option, the government will move away from a system of electoral democracy.

Japan will continue to hold regular elections, and parties will exchange places at the head of Japan's legislature. Beneath the surface, however, the ministries that make and implement policy will begin to reassert their autonomy from the legislature. This will reverse two decades of reforms aimed at strengthening Japan's legislative and judicial branches and increasing the major parties' power relative to key ministries, harkening back to the early post-World War II decades when the bureaucracy was autonomous from politics and informally controlled the nation. This autonomous civil service itself had roots in a much longer tradition of governing through a small cadre of administrative elites that reaches back to the Meiji Restoration and deep into Japan's feudal past. Once the new generation of administrators has secured its position, it will work to ensure that the core elements of Abenomics survive.

China's Continued Rise

Over the next five years, the regional security situation will become increasingly volatile; economic dislocation and political turmoil within China will combine with China's expanding military power. Urged on by the United States, Japan will become more proactive not only in its own maritime patrolling and reconnaissance activity but also in deepening cooperation with Southeast Asian partners. The sheer quantity of vessels and aircraft deployed in the region will raise the risk of short, sharp crises. Such incidents will ultimately serve to bolster popular support within Japan for a defense posture against Chinese aggression.

Greater volatility in the Pacific will fuel the rise of the new generation of activist bureaucrats and keiretsu leaders by underscoring the need for reform. By 2020, these rising civil servants and business leaders will have made significant headway in consolidating their influence within key ministries. Meanwhile, Japan will seek to capitalize on the increased integration of the Association of Southeast Asian Nations to expand Japanese influence in Southeast Asia and nearby India. Japan will pursue these goals with an eye toward containing Beijing, but they will yield benefits independent of China.

Forecast After 2020

Japan will enter the 2020s in a relatively strong position. Despite growing opposition from an electorate dominated by older voters, the government will be more successful than previous administrations in implementing reform. Breaking up the agricultural and other lobbies in the late 2010s will expedite the process. As the generation born before World War II leaves politics and tensions with China grow, nationalist sentiments in Japan will surge, allowing the government to more actively mobilize support for defense reforms.

The reform measures initiated under Abenomics will slowly come into force after 2020 but will fall short of generating sustained annual GDP growth above 1-2 percent. Demographics will undergird this poor performance: Between 2015 and 2020, Japan's workforce will shrink by 3.3 million, or about 4 percent, increasing the pressure on the economy's productive capacity. Reform measures, however, will help ensure relatively stable GDP, improved efficiency and productivity as well as constant quality of life. This will provide a workable basis for the government's efforts to revamp the country's regional and global image and extend its political, military and economic reach.

From 2020 to 2030, Japan's working-age population (ages 20-64) will fall by around 4.8 million to 5.6 million. This drop will be well below the decline of 7.7 million-8.3 million people from 2010 to 2020, but it will be substantial nonetheless. To maintain a constant GDP, Japan will need to ensure average annual productivity growth of at least 2 percent. Doing so will require securing labor reforms. It will also depend on the Japanese government's ability to stimulate higher value-added services (such as financial services) and computer technologies industries at home.

Fixing employment problems will be critical for supporting Japan's growing elderly population. Compared with the years between 2010 and 2020, when the country's over-65 population grew by 7.5 million, the rate of population aging will slow considerably in the 2020s. Still, the absolute burden of caring for Japan's elderly population will only grow. By 2030, people over 65 will account for 32 percent of Japan's population, as opposed to 56 percent of the population at working age.

Tokyo will make tangible progress throughout the 2020s in cementing reforms and encouraging the kinds of industries needed to improve the overall productivity of Japan's economy. But the Chinese and European economies will remain weak through the early 2020s, and Japan's internal changes are unlikely to generate enough taxable income to reverse Tokyo’s reliance on deficit spending. Japan probably will not default on its debt, given the high rate of domestic ownership, but the amount of debt will grow, as will debt servicing costs.

Japan's relations with China will be in flux between 2020 and 2030. Even as China's economy slows between 2015 and 2018 and the Chinese government struggles with rising unemployment and social dislocation at home, the United States, Japan and their partners in broader Asia will pull closer together to balance against the perceived Chinese threat.

Beijing will continue to invest in its military and maritime expansion, and the world will continue to expect an imminent Chinese economic recovery. This will fuel integration efforts by the United States and Japan. But before 2025, the limits to China's economic trajectory and military capabilities compared with those of the U.S.- and Japan-led coalition will have become unmistakably clear. This will coincide with the unleashing of long-suppressed social and political energies within China, a process that could reach a climax before the scheduled 2022 generational leadership transition. The extreme centralization of political power before 2020 will have thoroughly undermined the system of checks and balances within the Communist Party of China and will make for a tumultuous transition process.

Up to 2025, Japan's neighbors will continue to view it as the leading counterbalance to China. Before long, however, internal political turmoil and continued economic dislocation within China will start to put the brakes on this dynamic. Stratfor expects China's ongoing economic slowdown to bottom out sometime around 2020. Throughout the early 2020s, China will be engaged in a process of restructuring and rebuilding its economy, a process that will weigh on annual GDP growth through the late 2020s. It will not be until the end of the decade that China's painful restructuring comes to fruition and domestic consumption by the urban middle class emerges as a genuine driver of national economic growth. As a result, China will exist in a state of economic dysfunction between the leadership transition of 2022 and perhaps as late as 2029-2030, likely increasing regional economic fragmentation.

The United States will realize the state China is in and will begin to slowly adjust the U.S. position in the region. Washington will move to prevent a complete Chinese political and economic collapse, fearing that such an outcome would cause extraordinary disruption across East Asia and provide an ascendant Japan a chance to move beyond the United States. To prevent its displacement, the United States will move to constrain Japan while avoiding open displays of friction with the Japanese.

Thus, Japan will find itself in the second half of the 2020s caught between a recovering China and a United States more amenable to assist in that recovery. This strategic bind, combined with Japan's deepening demographic decline, could well pave the way for another period of relative introversion in the 2030s.

The rates of workforce decline and population aging will both remain moderate in the 2030s before picking up precipitously in the 2040s. Efforts to boost fertility rates in the late 2010s and 2020s may help counteract the effects of working-age and population decline after 2040, but by and large, their effects on Japan's workforce will not be felt in the 2030s. If fertility does improve, Japan's workforce (by 2040, only 52 percent of the population) could find itself even more financially strained than in the previous decade. By 2060, Japan's workforce will have declined by 50 percent since 2015, while the country's total population could fall by as much as 25 percent. With this in mind, the years after 2040 are likely to be increasingly dominated by internal economic and social management-related issues.

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